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FINANCE AND ECONOMICS
Bond bombshell
L O N D O N A N D N E W Y O R K
Government-bond markets are in turmoil. Expect more of the same
IT WAS, doubtless, a very reasonable view a couple of weeks ago. America's economy seemed to be not just booming but at risk of overheating. Inflationary pressures were rising and the Federal Reserve had been tardy in raising rates. Bond analysts warned that the yield of the most inflation-sensitive bond, the 30-year Treasury (commonly known as the long bond) would rise to 7% or more, as the price fell in line with the dismal trend of recent months: the yield on the long bond had risen by two percentage points, from a low of 4.75% in 1998 during the turmoil unleashed by Russia's default. Since then, investors have become used to rising yields and falling prices, and have wanted relatively little exposure to long-dated bonds.
As often seems to happen when everyone has the same view, they have been completely wrong-footed. Far from rising further, yields on long bonds have fallen. From a high of 6.76% on January 18th, the yield on the long bond fell, gradually at first, and then with the composure that only the financial markets can demonstrate (ie, panic), to a low of 6.05% on February 3rd. Indeed it moved by 25 basis points (hundredths of a percentage point) on that day alone. It has risen since, but the uncomfortable fact remains that there has been a short squeeze in what was considered, after foreign exchange, the world's most liquid market. Other bond markets moved in sympathyfurther evidence that some of the world's biggest financial markets are becoming more illiquid and hence more volatile.
In this latest case, the culprit, common wisdom has it, is America's Treasury. On the same day that the Fed raised short-term ratesusually bad for bond demandthe Treasury announced that it would be issuing fewer bonds and buying back more outstanding ones. This was hardly a secretwho has not heard of America's booming economy and its fabled budget surplus?
But investors were surprised at quite how quickly and how much the Treasury would buy back ($30 billion-worth this year), and at which bonds it bought. Until now it has mostly repaid short-term debt, lengthening the overall maturity of its borrowing. Now it seemed as if it wanted to correct this by snapping up longer-dated bonds: most of that $30 billion was to be spent buying back bonds with a maturity of longer than ten years. And since insurance companies and pension funds buy long-dated bonds to match their long-dated liabilities, everyone has been scrambling to acquire what appears to be a fast-vanishing assethence the soaring prices and plunging yields.
This has led to an odditywhat is dubbed an inverted yield curve: yields on long-term bonds have fallen below those of shorter-dated ones (which have barely budged). Normally the yield curve is positive because investors demand higher yields to compensate for the risk that inflation might pick up. Inverted curves are rare, and when they do occur, it is usually later in an economic cycle, when central banks, wary of inflation, jack up short-term rates. This time the curve has become inverted mainly because long-term yields have fallen so much.
Doubtless, the Treasury's role in fanning volatility in the bond markets led Larry Summers, the treasury secretary, to "clarify" the Treasury's position on debt repurchases on February 9th. These, he said, would not be just of longer-dated bonds but of all maturities. If his intention was to curb volatility, Mr Summers, a noted academic, failed. Yields on long bonds rose sharply in response.
But the Treasury's original announcement was not, in itself, enough to explain the speed of the movement in long-bond yields. Other factors have been at work. One, rumour has it, is Bill Gross, the fabulously well-paid manager of PIMCO, America's largest bond fund. Mr Gross is gloating over his huge purchases of long-dated bonds, and their effect on the market. "I think this time we are partly responsible," he admits.
But only partly. Mr Gross's prescience is matched only by the lack of foresight shown by many other bond-fund managers. They have been trying to boost their performance by shortening the duration (a measure that takes into account not just a bond's maturity but the interest it pays) of their portfolios. That strategy worked well when long-term bond prices were falling sharply. When long-term bond prices were rising, managers came to regret it. Bonds with a maturity of more than ten years account for a third of the value of all outstanding bond issues.
Demand for longer-dated government bonds has come from other sorts of fund managers too, such as those with portfolios of mortgage-backed securities (bonds secured against lots of mortgages). Borrowers are allowed to pay their mortgage loans back early, and are more likely to do so when long-term interest rates are falling. This shortens the bond's duration. To maintain their portfolios' durations, managers buy Treasuries.
Another reason demand for the long bond has been so voracious is that a lot of investment banks still use them to hedge their corporate-bond positions and interest-rate swaps (between fixed- and floating-rate obligations). As a hedge Treasuries have the advantage that, traditionally, they have been more liquid (and so cheaper to deal in) than, say, swaps. On the other hand, Treasuries do not move in lockstep with swaps. Far from it (see chart).
When the yield curve inverts, it also creates big disruptions in the swaps market, creating further demand for long bonds to unwind hedges. One rumourwhich the company has denied but which was current in the marketswas that General Re, a big insurance company that manages a large swaps portfolio, has been forced to liquidate its positions.
Underlying all this have been two other factors. The first is that both investment banks and hedge funds are less willing to take risk. Both types of institution use risk-modelling techniques, such as the ubiquitous Value At Risk (VAR) to mitigate their risks. In a descriptive sense, VAR models purport to tell users how much money they are likely to lose; in a prescriptive sense, it tells them what to do about it.
The first is to cut risky positions. Fine in theory; less pleasant in practice: the many institutions adopting this strategy have found that they drive the market against themselves, thus increasing losses and forcing them to sell more. This is one reason financial crises have become more frequent in recent years.
The second VAR prescription covers the amount of capital they devote to risk taking. Clearly, most banksunder pressure from shareholders that dislike the volatile returns from tradinghave decided to reduce it. "There's a lot less risk capital in the market," says a boss at one big investment bank. "Moves are amplified because there is not as much money at risk."
For these reasons, more volatile markets are not just a short-term phenomenonwitness the huge movements in many markets of late, not just in the Treasury market (see chart) but in currencies, gold and equities too: on February 9th, the Dow fell by 2.4%. At some stage, of course, investors will think that trading is a good business, because competition has been reduced and returns boosted. But not yet; and since other governments now have budget surpluses (see article), other bond markets will also be increasingly illiquid and volatile.
The corporate-debt market is the most obvious problem. How do you put a price on corporate debt? Its price used to be determined by looking at how much it yielded compared with government bonds of similar maturity. Now that government bonds are so pricey and volatile, some companies are loth to borrow at rates tied to them.
One answer has been to compare, say, 30-year corporate bonds with shorter-maturity government bonds. 30-year bonds issued by Vodafone AirTouch, a British mobile-phone company, were priced at a spread over ten-year bonds. But this incurs a big risk for investors: that the yields in bonds of differing maturities will move in different ways. Swap rates provide an alternative benchmark for corporate debt. Sophisticated investors and borrowers already price debt compared with swaps. Since the swaps market is, in theory, infinitely expandable, the market is not as susceptible to squeezes. But in the short term, shrinking government-bond issuance means greater volatility in a wide range of financial markets.